Performance That’s “Beyond Ludicrous”

July 31, 2007

I’m fortunate to have amassed a circle of readers that are passionate about my books. They offer me tips on improving them, suggest topics for further study, and tell others about them. An author can’t ask for more from his readers.

Sometimes, though, they protect me too much. My stock book is highly rated at Amazon.com, but not everybody rating it approves. When Nicholas E. Johansen awarded it a mere three stars and supplied some unflattering comments, readers reported the transgression to me within hours. One went so far as to suggest that I prove to Amazon that some of Mr. Johansen’s comments are not true and demand that they be pulled. I will not do that.

Instead, I’ll address some of what he wrote, focusing mostly on his skepticism around my permanent portfolios.

Mr. Johansen begins his review with a much-appreciated summation of what he considers to be good about The Neatest Little Guide to Stock Market Investing:

Kelly does an excellent job of defining various stock terms — everything from P/E ratio to beta — and doing it in simple language. As a side note, his writing style and prose is significantly better than that featured in most investing books, since he was an English major. Additionally, Kelly provides excellent research resources, including ones that I had not found in my extensive internet searches. More information and more sources is never a bad thing, and Kelly provides the latter in spades. Finally, his introduction to such investment greats as Warren Buffett and Peter Lynch — while rudimentary — are very helpful for the new investor. I find it particularly good that he utilizes Lynch extensively in his own strategy, because Lynch is (arguably) the best fund manager that has ever lived.

Lest you become too comfortable in this warm light, however, know that the English major benefits won’t outweigh the detriments to this reviewer before he’s done. He quickly moves on to the problems he sees:

Unfortunately, Mr. Kelly adds a bit of his own intuition and thoughts into the strategies he presents in this book. First and foremost, his notion that investing in the UltraDow mutual fund is sound is beyond ludicrous. Not only is this an ineffective use of money, but its volatility and risk far outweigh its gains.

Ah yes, the oldest objection in the book against my doubling strategies: they’re volatile.

Folks, here’s a tip for you: whenever an investment strategy has the word “double” in the title, it’s going to be volatile. When you double the performance of an underlying investment in both directions, you’re going to experience — by definition — twice the volatility of the underlying investment. What I show in the book is that doubling groups of reliable stocks such as the Dow and, in my new edition, the S&P; MidCap 400 index, is that they have always recovered in the past and that down moments in the market provide a wonderful chance to put more money to work at a discount.

I hammer this idea home regularly in The Kelly Letter. Commit it to memory: extreme volatility coupled with assured recovery is a potent combination.

You would not want to double the performance of a single stock because there’s a chance that the stock will decline so precipitously that you’ll lose all of your capital. That’s not the case with my doubling strategies because they target major indexes. In fact, I show that even if an investor began my Maximum Midcap strategy at the worst possible moment, its peak before plummeting, he or she would have been back at even within five years.

That’s comparing only the initial investment with no additional money added along the way. If, however, an investor was astute enough to buy more shares during the down times, as advised in The Kelly Letter, the margin of outperformance by Maximum Midcap was far larger. From its low in March 2003 to the end of 2006, the strategy returned 272%.

This is no small feat. The dot.com crash of 2000 to 2002 was the worst bear market of my career so far, and likely the worst of my lifetime. The Nasdaq plunged 78%, after all. It doesn’t get much worse than that.

Yet, even investing in this strategy at the worst possible moment of one of the worst bear markets of our lifetimes did not produce financial ruin. In fact, the intelligent investor who followed my advice to keep investing during the worst months was back to even within a couple of years and is now counting substantial gains.

Even right now, we’re seeing the volatility in action. The Kelly Letter invests more money in each of my doubling strategies at the end of each month. That happens to be today. You know what happened last week? The market sold off and my Maximum Midcap strategy, true to form, fell twice as much as its index. It dropped 12% in a week.

Sounds terrible, right? However, if you look at the long history of the index itself you’ll understand that such downdrafts are just part of the pattern. When the index turns up again as it always has, shares bought at the 12% discount will roar back with twice the vigor of the market itself. That’s the beauty of this approach.

Subscribers received a reminder email last night to buy more shares today. You can see how they’ve fared over the years we’ve been using this strategy here.

If that’s “beyond ludicrous,” join me in the crazy camp. There is no evidence that these doubling strategies entail volatility and risk that far outweigh their gains, as Mr. Johansen claims.

He then attacks what he perceives to be my lack of professional training:

In the preface, he states that using this book “always works” — a pretty bold statement from someone who is A) not a business major and B) not really even a market professional. Only later, towards the very end of the book, does Kelly admit that he has “limited experience” in the area of stocks. Er…what was this about “this book always works”? Kelly’s strategy is, in essence, based upon filling out a worksheet and setting arbitrary numbers as “good” or “bad” — i.e. when X ratio outweighs Y number, this stock is a good buy. Get enough of these “good buy” signs together, and you have a stock to buy. Not only does this show his lack of knowledge on the subject, but worse, he makes these statements as if they are guaranteed to make you money.

This part is just plain untrue. Nowhere in my book does the phrase “limited experience” even appear.

As for my worksheets, what stock worksheets do you know that don’t compare numbers and ratios to benchmarks and competition to see how they stack up? I’m not sure why Mr. Johansen considers that to be a bad approach. I never imply to readers that getting enough good measurements together automatically produces “a stock to buy.” In fact, here’s an excerpt from page 24 of the book pointing out the uncertain nature of stock analysis:

The annoying thing about stock measurements is that even if every one of them gives a green light to a stock you’re considering, it might still end up being a bad investment. It’s not like measuring your inseam. Once you know that number, you know the length of pants to buy and if they’re that length, they fit. Period. It’s not that simple with stocks.

I’ve been wrong on stocks. So has everybody who’s ever worked in this business. It’s part of the business. What I tried to do in my book is give the reader an edge over the odds by showing certain measurements that have worked and are better than nothing when it comes to understanding a company.

With no measurements, we might as well throw darts or roll dice. We need measurements to determine what a company is worth, compare what it’s worth to its current price in the market, and determine if we have a chance to buy it at a discount and benefit when the market awards it the value that it’s worth.

As for my having studied English instead of business, guilty as charged. I don’t consider that to be a weakness and, apparently, neither do others in this business. I interviewed Bill Miller in May for subscribers. He’s famous for having beaten the S&P; 500 for 15 years in a row from 1990 to 2005 at the helm of Legg Mason Value Trust. Know what he studied in college? Philosophy.

Next, Mr. Johansen has a few choice words for beginning investors:

Interestingly enough, Kelly almost always talks about buying shares in the HUNDREDS. That’s right, as in 200 shares of Microsoft. Almost anyone who knows something about the market will tell you that investing $5,000 or even $10,000 will yield underwhelming results. The # of shares Kelly is dealing with proves to show that he is not only small time (re: has not made a lot of money off trading) but probably hasn’t been at investing for very long.

Clearly, Mr. Johansen was not an English major. The first thing writers learn is to know their audience. My book is for beginners. I deliberately designed my examples to be near the amount of money that my readers are likely to be managing when they first approach the market.

Besides, what works for $10k works just as well for $100k. It’s like swimming. You learn to do it in water that’s shallow enough to allow standing when you make a mistake. What you learn in that shallow pool, however, will get you through the deepest waters later.

And, if any reader doubts my own authority on the subject, just look at whose advice appears in my book: Benjamin Graham, Philip Fisher, Warren Buffett, Peter Lynch, William O’Neil, and Bill Miller with historical perspective provided by James O’Shaughnessy and cameo appearances by Susan Byrne and Charlie Michaels. This is an all-star roster and maybe, just maybe, combining their wisdom as top performers in the investment business with the writing skills of a lowly English major is precisely what a beginner needs to take those first few steps.

Not just beginners, either. You don’t get higher in the world of investing than the people whose advice I capture in my book. Any investor will benefit from distillations of their advice. About my summary of his techniques, Bill Miller wrote, “Jason Kelly captured my investment methods well, and better than most who have tried to describe what I do.”

I appreciate Mr. Johansen’s taking the time to write a review of my book. I also appreciate the many kind readers who worried about my well-being. Rest assured, I’ve withstood more vicious attacks on my strategies and more scathing indictments of my education.

None of it matters as much as the facts. My book does always work. I track everything in it on this site and in my weekly advice to subscribers. There are fewer and fewer critics of my methods as the years go by. Why? Because my strategies are beating almost everybody.

Even Bill Miller, much as I respect and admire him, is behind my Maximum Midcap strategy through the dot.com crash to now. Of course, his performance was far less volatile and that’s a different kind of victory. What I’m proud to show is that my strategies are some of the best ever explained to beginning investors, the overwhelming majority of whom invest more money each month or quarter to achieve their goals.

That approach, known as dollar-cost averaging, has no better friend than my volatile but skyward reaching strategies, Double The Dow and Maximum Midcap. Just as The Kelly Letter is doing today, Tuesday, July 31, buying more when the price is down and waiting for the eventual turbo-charged recovery has proven to be a winning approach to the market.

I hope you’re not too disappointed that it was brought to you by an English major.

Tomorrow: A response to my Power Investor article from the software’s publisher, The Investors Alliance.

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